The Impact of Moral Hazard and Budget Balancing on Sorting in Partnerships

Team production is an important contributor to economic activity and its significance has been increasing with rising degrees of specialization. Understanding how agents with heterogeneous characteristics organize in teams, and how the process of team formation can be impacted by prominent economic frictions, is an essential step in answering many empirical and policy questions. This paper argues that moral hazard, in conjunction with budget balancing (as in the classic moral-hazard-in-teams-problem in \cite{holms1}) creates incentives for the high-skilled agents to team up with the low-skilled ones. This occurs because of how the optimal contract used in the presence of moral hazard and budget balancing varies across different partnerships. As a result, organizing in heterogeneous teams allows to distort the effort of the most productive agents to a lesser degree. Numerical experiments demonstrate that this mechanism is quantitatively significant and may rule out positive sorting despite substantial degrees of complementarity in the underlying production technology. Thus, contrary to common intuition, the formation of "mixed team" does not have to be the outcome of sub-modularities in the production technology (e.g., due to learning from each other) but, instead, may be driven by the presence of moral hazard.